Is Game Stop the next Blockbuster?

Nigam Arora is an engineer, nuclear physicist, author, and entrepreneur and
the founder of two Inc. 500 fastest growing companies. He is also the developer
of the ZYX Change Method
to profit from change by investing. The premise is that most money is made by
predicting change before the crowd. Arora is the chief investment officer at
The Arora Report and the
editor of four newsletters that track the ZYX Change Method. Nigam can be
reached at Nigam@TheAroraReport.com.

Game Stop is a retailer with about 6,600 stores, mostly selling physical video games. Shrink-wrapped video games are becoming obsolete; it is only a matter of time before consumers stop buying them. So why buy the stock?

Looking at Game Stop
GME, -0.67%
the stock has run up 25%, as show on the chart, since it reported lousy earnings on March 27, 2014. It is being highly promoted by bullish gurus who seem to be oblivious to the history of what happens when the landscape changes.

In my mind, there is an uncanny similarity between Game Stop and Blockbuster. At its peak in 2004, Blockbuster had 9000 stores renting videos. Then came competition from Netflix
NFLX, +2.47%
with its DVD-by-mail service, Redbox which is a subsidiary of Outerwall
OUTR, -13.44%
renting videos from automated kiosks, on-demand video from cable providers such as Comcast
CMCSA, +0.08%
and streaming video. The mighty Blockbuster ended up filing for bankruptcy.

History is full of examples of the mighty falling when the new landscape develops and the old business model does not work well. Another classic example here is Radio Shack
US:RSH
which once traded at $79.50 is trading at $2.26 as of this writing.

Eastman Kodak was once a blue chip and part of Dow Jones Industrial Average primarily on the strength of photographic films. When digital cameras took hold, the mighty Kodak ended up filing for bankruptcy.

Changing landscape

Console makers such as Microsoft
MSFT, -0.38%
and Sony
SNE, -2.64%
are increasingly encouraging digital downloads of games. As consumer habits change, there will be no need to go to a store such as Game Stop.

Even more dangerous to Game Stop is streaming games. This summer Sony will launch a service to allow PlayStation 4 owners to directly play games over the internet.

Rise of the casual gamer

The rise of the casual gamer has subdued growth in the hard-core gaming market that Game Stop caters to. On Tuesday, Amazon
AMZN, -0.11%
announced a new streaming device with lots of emphasis on casual gaming. Some of the biggest-selling apps on Google
GOOG, -1.10%
Play Store and on Apple
AAPL, -0.87%
iTunes are games. Game Stop is simply not positioned where the growth is.

Wal-Mart competition

Game Stop generates a big part of its earnings from buying and selling used games. Now Wal-Mart
WMT, -0.25%
has announced it is entering this segment. There is already evidence that in stores located close to Wal-Marts, Game Stop is becoming more aggressive and reducing its margins.

Bull's arguments

Bulls argue that Game Stop will change its business model. So far, such efforts have not succeeded. About three years ago Game Stop bought a video-game streaming company Spawn Labs with great fanfare. This service has been unable to compete and Game Stop has been forced to close Spawn.

Bulls also argue that Wal-Mart will not be able to compete well with Game Stop in used games, but bulls forget that the business of trading used games is becoming obsolete. Wal-Mart is simply being opportunistic to generate traffic.

They also argue that the company has no debt, which is true. But analysts do not take into account that the quick ratio, which is determined by adding accounts receivables to cash and marketable securities and dividing by current liabilities, is about 0.35. A quick ratio less than one means that the company cannot quickly pay back its current liabilities.

Bullish analysts also contend that Game Stop is growing faster than the industry. Again, it is true, but Blockbuster was also growing faster than its industry. The argument becomes meaningless when the industry goes into a rapid decline.

Game Stop earnings fell by about 12% the last quarter year over year. After being wrong about the last-quarter earnings, bullish analysts consoled themselves by claiming that the earnings will be better the rest of the year.

First, in the last quarter when new consoles Xbox One and PS4 along with many new games came to the market, the company was not able to meet earnings projections. Going forward there are no new gaming consoles, the bulls speculate that the gamers will buy more games for the consoles that they bought in the last quarter. Even if the speculation proves to be correct, the real question is what happens in 2015? Anyone who was trading with real money Blockbuster, Kodak, and Radio Shack will readily see the folly of extrapolating the past numbers into the future when the future is likely to dramatically change.

Blockbuster repeatedly tried to change its business model but failed. Many gurus during the decline of Blockbuster, Radio Shack and Kodak had an almost continuous chorus of bullish pronouncements regarding new business models. I believe a similar fate is ahead for Game Stop. The current strength in Game Stop is a selling opportunity.

Disclosure: Subscribers to The Arora Report have long positions in Apple and Wal-Mart.

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